The following are some guiding principles, which can be used to help keep your self directed investing on the legal path. They are not all inclusive. There are number of exceptions to these principles, some well founded, others more risky or dubious. So if you have a question about whether a certain investment strategy that doesn’t conform to these principles can be made to work, please contact us.
The Law was Enacted to Help People Save for Retirement, Not to Raise their Standard of Living:
The purpose of retirement plan laws is to provide an income for your retirement years and to keep you off the government dole during those years. While a self directed retirement plan can be a very effective wealth building tool, keep in mind that was not Congress’s focus in granting favorable tax treatment for such plans. In addition to the tax advantages of deferment or (in the case of Roths) tax free growth, Congress has protected your retirement funds from your creditors. Naturally, these advantages come with some significant strings.
Preference for Passive Investments:
One of the key limitations of retirement plan law is a preference for “passive” investments, i.e., generally long term buy and hold strategies with little direct contact with the investment. For example, strategies that involve real estate flipping can run afoul of these limitations because it may look more like an active business.
Preference for Safe Investments:
In granting the special tax treatment given retirement plans, Congress had in mind a low risk savings strategy that produced results for all involved rather than a high risk strategy that produced winners and losers. Therefore, IRAs are prohibited from investing in certain assets, e.g., “collectibles” (e.g., art, coins, etc.), life insurance, precious metals, and certain other assets. Although these same limitations don’t apply to 401(k)s, an overly aggressive investment strategy will likely run afoul of one of the other limitations.
No personal benefit or use:
Humans are great at rationalizing. In the 401k / IRA investment realm, the rationalization generally goes like this: ”If I make money, and it goes back into my retirement fund, that’s good for my retirement.” That thinking is then used to justify a use in which the investor derives some current benefit. But a central tenet for granting favored tax treatment to retirement plans was that the investor derive no current benefit or use from the investment. A current benefit or use means current taxation. Accordingly, direct or indirect (e.g., renting to certain relatives) benefit, use, or even contact with the investment asset may result in a taxable distribution or disqualification of the retirement plan.
No business use:
A cottage industry has developed around “unlocking” retirement plans to help fund the plan owner’s start up business. These schemes typically operate in a grey area utilizing certain provisions of the law in a way not envisioned by Congress when it enacted the law. (These schemes require the use of a 401(k) employee stock ownership plan – ESOP, not an IRA.) Moreover, these strategies run contrary to most of the aforementioned policies underlying the special benefits granted to retirement plans, i.e., investments that are passive, safe, and with no current benefit or use. Although there has been no definitive prohibition by the IRS or courts against the most popular of these strategies (, they are being closely monitored by the IRS and pose a risk to the investor utilizing them.
Summary:
As you can see, purchasing rental real estate fits well into these principles. Exceptions to these principles can include borrowing from a retirement plan, using a 401(k) to provide equity funding for a business owned by a retirement plan owner, renting to certain “horizontally” related relatives, and applying for a specific exemption from a prohibited transaction. Such exceptions are governed by very detailed and tricky regulations requiring professional guidance.
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